Judge Richard Posner and economist Gary Becker have joined the ranks of academic bloggers that have turned their considerable intellects to the topic of bankruptcy reform. I expected a real treat, but their recent comments on the pending bankruptcy bill are so out of touch (and out of date) that I was amazed to see them advanced. Posner and Becker’s entire discussion rests on the standard chestnut that the bankruptcy bill will benefit consumers because it will reduce creditors’ risk and therefore cut interest rates. That argument not only ignores twenty years of data; it also perpetuates a plodding “perfect markets” model of consumer credit that most theorists have long since abandoned.
Start with a brief look at the data. Bankruptcy write offs represent about half of the total bad debt writes, which would suggest that they ranged from 1% in 1985 to 2.5% in 1992. Much larger is the cost of funds, which is the amount companies must pay to borrow the money they lend out. From 1980 to 1992, that cost fell from 13.4% to 3.5%, a stunning decrease in costs. What happened to the interest rates the companies charged? In the same time period, the average credit card interest rate rose from 17.3% to 17.8%. Move the clock forward a bit. When the cost of funds dropped nine times in 2001, instead of passing along the cost savings, the credit card companies pocketed a windfall of $10 billion in a single year. So much for the idea that the credit card companies are lined up to pass savings along to the customers.
Posner and Becker imagine a credit card market that simply does not exist. A WSJ piece by Mitchell Pacelle described a changing market:
Until the early 1990s, most banks offered one main credit-card product. It typically carried an annual interest rate of about 18 percent and an annual fee of $25. Cardholders who paid late or strayed over their credit limit were charged modest fees. Profits from good customers covered losses from those who defaulted.
Then card issuers, in an effort to grab market share, began scrapping annual fees and vying to offer the lowest annual interest rates. They junked simple pricing models in favor of complex ones they say were tailored to cardholders’ risk and behavior.
According to the WSJ, a typical credit card contract was “little more than a page 20 years ago [but runs] to 30 pages or more of small print today.” Universal default, undisclosed penalty rates, arbitration clauses, undisclosed amortization rates — the combination of complex language and missing terms makes the contracts indecipherable even for those who have secret decoder rings. The credit card companies have fought like tigers to avoid telling customers the basics — if you make the minimum monthly payment, you’ll pay $xx in interest and it will take you xx years to pay it off. This non-closure is so that credit card companies can compete to lower fees?
A number of younger economists have explored credit card pricing, developing a much more nuanced theory of how it exploits lack of consumer information and systematic cognitive errors. Oren Bar-Gill penned a detailed analysis of how credit card companies use dozens of tricks in their contracts to encourage customers to underestimate costs and overestimate their repayment schedules. He shows that even in a competitive market, these pracrices can lead to welfare losses. Lawrence Ausubel has demonstrated that, while people will shop for introductory interest rates, they are far less likely to re-shop when new fees and penalty rates are imposed on them. A recent article in the Quarterly Journal of Economics by Stefan Della Vigna and Ulrike Malmendier examines pricing strategies in various consumer markets and concludes, “for all types of goods firms introduce switching costs and charge back-loaded fees. The contractual design targets consumer misperception of future consumption and underestimation of the renewal probability. The predictions of the theory match the empirical contract design in the credit card, gambling, health club, life insurance, mail order, mobile phone, and vacation time-sharing industries.” The lesson is clear: credit card companies can maximize profits by pricing introductory rates competitively and then hitting customers hard later on with fees and penalties. And that model certainly seems to fit the data on revenues. Today, credit card fees and late charges amount to $50 billion — about half of all credit card revenues.
If Posner and Becker wanted to put their simple model to good use describing a perfect market, then why didn’t they question why the proposed changes in the bankruptcy laws would apply to all outstanding debt? Existing credit card debt was priced based on current laws. Billions of dollars are outstanding in fixed-term loans. The bankruptcy bill would change the terms of those loans by limiting the availability of the bankruptcy discharge — a nice windfall for the creditors who face lower risks. If the law isn’t designed to be a give-away to the creditors, why not make the new rules applicable only to loans made after the effective date of any amendments — when those new, low Posner-Becker interest rates will be in effect?
The credit card companies didn’t spend tens of millions of dollars for campaign contributions and high-dollar lobbyists so that they could pass legislation to save money for their customers. They paid for a law that will let them squeeze ordinary working folks harder. They want a law that will maximize profits from their richest source — those who stumble. And if that law put more people directly in the line of file when they lose their jobs or get sick or get called up to military duty, that’s just the way it works when the companies have the power to write the laws. The credit card companies want a law that will give people caught in 35.99% hell no chance to escape, no matter what.
Posner and Becker talk at length about debtors’ willingness to incur credit, but nothing in the bankruptcy bill distinguishes credit issued for a fabulous vacation and credit issued to cover hospital bills or put food on the table during a long spell of unemployment. It is all treated the same, which undercuts the Posner-Becker notion that consumers have their fate in their own hands every time they sign a credit slip. Europeans have universal health insurance, better unemployment protection, and tougher bankruptcy laws; to make the bankruptcy laws in the U.S. tougher when shrinking health insurance coverage and growing unemployment and outsourcing tear away at middle class families is simply to ignore facts that don’t fit the model.
I know that it is fun to think of every market in terms of simple “if I had a nickel and you had a banana” models, but when Congress is on the verge of passing a massive give-away to credit card companies, a little more realism seems called for.